EM evolution: New paths in equity portfolio construction

Over the past couple of years, our discussions with investors have at times revealed emerging market (EM) portfolio policies that are stuck in the past — in some cases, policies that were established a decade or more ago. In that span, we’ve witnessed massive change in the EM universe, including a near doubling of China’s weight in the MSCI Emerging Markets Index from 17.4% to 31.4%.¹

We believe the time has come for EM equity exposures to evolve. In this paper, we lay out a simple framework investors can use to structure their EM equity portfolios given the wider range of implementation approaches available today. We also address the active/passive decision in EM portfolios and offer ideas on the manager selection process.

Why do EM equity exposures need to evolve?

Emerging markets accounted for 11% of the MSCI All Country World Index as of 30 September 2022, up from just 5% as recently as 2004. As a result of this growth, investors trying to capture the global opportunity set today generally include EM equities, with the starting point for many being to size allocations to emerging and developed markets according to their weight in the global equity universe. Increasingly though, investors are looking beyond market-cap approaches and making sizing decisions based on valuations, expected returns, and other factors.

Our focus here is on the construction of the EM equity exposure once the sizing decision is made. Over the past decade, the universe of EM equity strategies has expanded greatly, and we believe EM equity exposures should evolve to take advantage of the many opportunities this universe provides to pursue attractive returns.

In the framework shown in Figure 1, we have broken the universe of EM equity strategies into three categories. EM 1.0 includes broad passive strategies that follow a cap-weighted benchmark. EM 2.0 (illustrated in more depth in Figure 2) includes “core active” strategies — that is, broad, diversified strategies that seek to take advantage of inefficiencies in emerging markets through bottom-up security selection or top-down country and sector selection. EM 2.0 may also include quantitative strategies, whose disciplined approach can be well suited to the large opportunity set and high transaction costs in emerging markets.

EM 1.0 and 2.0 strategies are already widely used by investors. Our framework pairs them with EM 3.0 strategies, or what we call “differentiated active” strategies. These are niche-ier strategies that tend to have less reference to cap-weighted benchmarks (higher tracking risk) and therefore may be more diversifying in a portfolio. 

Figure 1

Figure 2

Understanding EM 3.0

There are a variety of approaches that may fit the EM 3.0 criteria for differentiated active strategies. As shown in Figure 3, they include strategies that:

• Leverage a manager’s deep local expertise by investing in a specific country or region — For example, a manager specializing in Asian equities is likely to have a better understanding of the very meaningful disparities between different countries in that region than a manager of a broad EM 2.0 strategy.
• Tap into opportunities in emerging markets that are already commonly pursued in developed markets — Analyst coverage of small-cap stocks in emerging markets may be modest, and strategies that invest in value stocks, while often global in theory, may in practice have less EM exposure than one would expect.
• Focus on frontier markets outside the “core” EM countries — Frontier markets are often the most thinly traded and transaction costs can be high, but the growth opportunities can be substantial. These can be stand-alone strategies or components of broader EM portfolios.
• Take on higher tracking risk — While it is increasingly common to seek out concentrated, high-conviction, high-active-share strategies in developed markets, there has been relatively less focus on these opportunities in emerging markets.
• Have a novel style or sector focus — Examples include strategies that target very narrow opportunity sets (e.g., high-quality Asian technology companies) or have a differentiated focus. 

Figure 3

Putting our EM framework to the test

To research the three categories of EM strategies in this framework (EM 1.0, 2.0, and 3.0), we screened the eVestment database and focused on EM strategies with at least a 10-year track record. Two caveats to note on the eVestment data: It is self-reported by managers and it is gross of fees. That said, we believe the data is useful for deriving a general picture of existing strategies that could fit this three-part framework. Specifically, we screened for strategies that were identified by their respective managers as passive and benchmarked to a broad EM index (EM 1.0), active strategies that appeared to have broad EM coverage and had tracking risk below 5%² (EM 2.0), and active strategies that had tracking risk above 5% or were benchmarked to specialized indices that were mapped to the characteristics shown in Figure 3 (EM 3.0).

Figure 4 provides an overview of the findings, including the number of strategies in the analysis, the average number of positions per strategy, the average active share of the strategies (active share is a measure of the degree to which a portfolio’s holdings differ from those in the benchmark index; the higher the active share, the greater the difference), and the average turnover of the strategies. A few observations on the data:

• The average active share of the EM 1.0 passive strategies was about 17%, which suggests that these strategies are not as passive as one might expect. (By comparison, the active share of passive large-cap US strategies is often close to zero.)
• As one would expect, the EM 2.0 core active strategies had a narrower set of positions than the EM 1.0 strategies, but they still had fairly broad portfolios with 255 names on average.
• The number of EM 3.0 strategies was high, which is not surprising since there are a variety of ways to define differentiated active strategies. On average, these strategies were more concentrated, with about half as many positions as a typical EM 2.0 strategy. Active share was somewhat higher at 77%.

Figure 4

Next we looked at historical results for the three categories (Figure 5) and found that over the 10-year period ended 31 December 2021, the EM 2.0 core active strategies outperformed the EM 1.0 passive strategies on a total return basis. Further, the EM 3.0 differentiated strategies outperformed both the core and the passive strategies. One observation that may be counterintuitive is that the EM 2.0 strategies had slightly lower volatility than the EM 1.0 strategies, and the EM 3.0 strategies in turn had lower volatility than the EM 2.0 strategies — all this despite the fact that the active managers take additional risk relative to their benchmarks. This suggests that the active managers differed from the benchmark in ways that helped to bring down the total volatility of their portfolios — perhaps by being less tied to the economic cycle than the broad EM indices. The active tilts they made in search of higher returns had the added benefit of reducing total portfolio risk. (To the extent that some of these managers take a thematic approach, these results would be consistent with our finding that thematic investments are less influenced by the cycle, as discussed here). This is reflected in the Sharpe ratios shown in Figure 5 — the risk-adjusted returns that the EM 3.0 managers generated ended up being meaningfully higher than the market as a whole. 

Figure 5

We also took a closer look at some of the EM 3.0 subcategories, including the number of strategies and their median five-year tracking risk, as shown in Figure 6. We would note that the EM 3.0 category is rich not just in the number of strategies but also in the breadth of the opportunities available.

Figure 6

As investors revisit their EM equity allocations, we believe the framework of EM 1.0, 2.0, and 3.0 can help them construct better portfolios. We’re not convinced that EM 1.0 strategies have much merit in today’s world (see the next section on the use of active and passive management in emerging markets). For most investors, we don’t think EM 3.0 strategies should replace EM 2.0; rather, they should be considered complementary. For example, Figure 7 shows the impact of combining EM 3.0 allocations with EM 2.0 allocations. Consistent with what was shown in Figure 5, the addition of the EM 3.0 strategies produced a slight increase in total returns and an increase in tracking risk. And again, the volatility actually came down modestly as the allocations shifted away from the EM 2.0 strategies and into the niche-ier EM 3.0 strategies.

At the same time, we think investors should ensure that their EM 2.0 allocations are diversified along different dimensions (e.g., bottom-up and top-down strategies). In a world where we may see increasingly divergent results across emerging markets, having some exposure to more top-down-oriented strategies could add value. We would also note that some of the appealing characteristics of EM 3.0 (e.g., potential for lower portfolio volatility and greater diversification) can also be found in EM 2.0, if one searches them out. Above all, we believe investors should ensure that their EM 2.0 exposures — in aggregate — don’t add up to a costly and trade-intensive benchmark-hugging (i.e., passive) approach.

Figure 7

Should EM exposures be implemented with active or passive strategies? 

While it will come as no surprise that we have a strong view on the advantages of active management, we also recognize the appeal of passive investments based on cap-weighted indices, including low costs and scalability. Increasingly, investors we speak with are thinking not in terms of “active or passive” but instead how to allocate between the two. We believe these allocation decisions should be based on a number of factors, including whether there is some degree of inefficiency that an active manager can potentially take advantage of and whether an index is aligned with the investor’s goals. On the first point, it has long been asserted that emerging markets are among the most inefficient markets, and research by our Fundamental Factor Team backs that up, as shown in Figure 8. Another potential source of inefficiency not reflected in the table is the fact that corporate governance standards vary widely across emerging markets, and active strategies that allow for more scrutiny of these issues may add value over time.

Figure 8

In terms of alignment with an investor’s goals, we believe there are several compelling arguments for allocating all or most of a portfolio to active strategies:

EM indices tend to be backward looking — Ask investors why they allocate to emerging markets and they will often cite the growth opportunities expected as these countries undergo fundamental shifts in the size and composition of their economies. But EM indices tend to be dominated by “first generation” companies that were able to grow, profit, and go public when these countries were in the early stages of development (e.g., natural resource companies and exporters). Companies more likely to benefit from future domestic economic development (e.g., health care and consumer services) are often not as well represented in the indices.

This may mean that index-based EM strategies are misaligned with the return goals of investors seeking to tap into the higher growth rates and development trends that emerging markets may offer. The backward-looking nature of EM indices may also affect the potential risk-reducing benefit of an index-based EM strategy. For EM exposure to be diversifying relative to developed market exposure, the performance of the EM exposure should be tied to the idiosyncratic growth drivers of emerging markets — but in practice, the companies that dominate these indices may, as noted earlier, be tied more to the global economic cycle.

EM indices may have country exposures that don’t fit investors’ goals — Country weights in EM indices can vary greatly over time. For example, countries can fall prey to “fads” as investors chase opportunities in the latest hot market, leaving some markets overvalued and others undervalued. Active managers may be able to add value by making top-down allocation decisions across countries, overweighting countries that are cheap and underweighting those that are expensive.

Passive may not be much of a bargain in EM — The light-blue line in Figure 9 shows that the average passive EM equity manager in the eVestment database has underperformed the average active EM equity manager and, perhaps surprisingly, the index itself. Normally one would expect passive manager results to be close to zero on a gross-of-fees basis. But in this case, they are often below zero. Passive managers can face high transaction costs as investors move capital in and out of the portfolio. They may seek to mitigate these costs by holding a subset of the broader universe — namely, the more liquid stocks. But that can lead to underperformance if/when the less liquid stocks outperform. In addition, fees charged for passive management in EM are often several times higher than those for passive management in developed markets. In short, EM may be not only a (relatively) less attractive market in which to pursue passive investing, but also a more expensive one.

Figure 9

A few thoughts on manager selection

In addition to deciding which types of EM strategies to pursue, investors must consider which managers to hire. As multi-asset strategists, we focus a great deal on manager selection and find that answering these questions can help narrow the search:

What is the source of the manager’s competitive advantage? In other words, what is it about the manager’s philosophy and process that can potentially generate performance above and beyond the index? And what makes the manager’s competitive advantage sustainable?

How does the manager’s approach link to the challenges and opportunities that are specific to EM markets/benchmarks? For example, how does the manager seek to take advantage of the fact that there may be less sell-side coverage in emerging markets? How does the manager address the higher levels of macroeconomic risk and the sector concentration that tend to be characteristic of emerging markets? How does the manager think about the lower level of regulatory oversight in many emerging markets?

How do different strategies relate to each other? When constructing a portfolio with multiple managers, it’s important to determine the extent to which their strategies are truly different from one another in the ways that they pursue alpha (e.g., top down vs bottom up or fundamental vs quantitative).

Conclusion

In summary, investors should revisit their EM exposures (many are already thinking about their China allocations, which we discuss below) and consider complementing EM core equity strategies with niche-ier “EM 3.0” strategies to help round out an overall allocation and potentially improve diversification. We also see a strong case for adding to active strategies in emerging markets, given the challenges in constructing EM indices and the opportunities created by EM inefficiencies. 

¹Source: FactSet, MSCI; 10 years ended 30 September 2022 | ²Tracking risk below 5% for the trailing 3-year period ended 31 December 2021.

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Important disclosures and risks

Sample EM 2.0 and 3.0 allocations (Figure 7)
The sample allocations are not representative of an actual portfolio. They are based on strategies and results from the eVestment database as of 31 December 2021. The strategies fall into three categories as follows:

• EM 1.0 (Passive) contains broad, passive EM strategies
• EM 2.0 (Core) contains broad, active EM strategies
• EM 3.0 (Differentiated) contains differentiated, active strategies that align with one of the following subcategories: Country, High Tracking Risk, ESG, Small Cap, Frontier, or Regional

Additional information is available upon request.

Emerging market risks
Currency – The value of investments may be affected by changes in currency exchange rates. Unhedged currency risk may subject portfolios to significant volatility. Capital controls may impair a company’s ability to return capital. 

Capital — Investment markets are subject to economic, regulatory, market sentiment, and political risks. All investors should consider the risks that may impact their capital, before investing. The value of your investment may become worth more or less than at the time of the original investment. Portfolios may experience high volatility from time to time. 

Emerging markets — Emerging markets may be subject to custodial and political risks, and volatility. Investment in foreign currency entails exchange risks. 

Manager — Investment performance depends on the investment management team and their investment strategies. If the strategies do not perform as expected, if opportunities to implement them do not arise, or if the team does not implement its investment strategies successfully, then a portfolio may underperform or experience losses